Infrastructure debt looks to be the preferred route for many investors, but should they focus on the primary or secondary market? Bob Dewing explores the pros and cons
Infrastructure is a hot topic for institutional investors. In the UK, the Pensions Infrastructure Platform (PIP) is a new initiative aimed at getting pension funds involved in financing public building projects, while in the US President Obama’s ‘partnership to rebuild America’ will offer tax breaks to overseas institutions investing in infrastructure.
Infrastructure debt is arguably an ideal investment for institutional investors with long-term liabilities, as the predictable and reliable cash flow of infrastructure debt can be a good match for these liabilities. Decades of excellent credit performance and risk-adjusted returns have attracted investors wishing to achieve better returns from sovereign, or near-sovereign, portfolios without taking unacceptable risks.
Essentially there are two ways for institutions to access infrastructure debt. The first is to originate loans in the primary market – this is the strategy behind ideas like the PIP. The second is to buy loans in the secondary market, where there is plenty of supply as the banks that originated the loans look to divest them to reduce the capital charges under Basel III.
Let us look at each approach based on default probability, asset diversification, speed to deploy capital in volume, interest rate management and execution risk.
Annual default rates of senior infrastructure loans historically decline over the life of a project as construction and start-up risks pass and the remaining operational risks wane.
From this perspective, a secondary market approach has the advantage. Acquiring mature assets allows for the evaluation of projects that have already passed the period of highest default risk. Theses assets will have already demonstrated operating and financial performance leading to more attractive credit expectations.
While the infrastructure debt asset class as a whole has low default rates, covariance of defaults within sectors and by geographic region exists. Prudent investors should own portfolios that are diversified across sectors, jurisdictions and currencies. Achieving a reasonable level of diversification is easier to accomplish within the secondary market due to the greater variety of loans available. The tendency for assets to be developed in cohorts by sector and region – for example, a boom in the building of Spanish toll roads or British schools – can also limit the diversification achievable in the primary markets.
Deploying capital is more efficient in the secondary market, with transactions being executed and funded as quickly as in a few weeks. In some cases, primary market transactions take months or years to complete. Furthermore, a delayed draw down (common during the construction phase of projects) can extend the funding period in the primary market. In the secondary market an investor selects loans, signs documentation and purchases assets at the rate the capital is desired to be deployed.
Interest rate management
Since the early 1980s, the primary market for infrastructure debt has been dominated by banks, generally holding around 90% of all debt originations, typically with the intent to hold until maturity. As a result, the majority of the market is floating rate. Conversely, institutions such as pension funds, which have known liabilities, tend to prefer a fixed income. As more institutional investors have entered the primary market, some borrowers have been willing to tailor their borrowing rates and basis to individual investor, obviating the need for swap contracts if a bank-style structure is unattractive to an investor. Thus, the primary market can offer a more tailored and less complex fixed-rate execution than through swapping the interest payments in the secondary market.
Institutional investors may prefer the greater certainty of investing in loans that are already in operation. In the primary market, many proposed deals never reach financial closing, despite intensive underwriting efforts.
Whichever approach investors choose, infrastructure debt is here to stay. The primary market may increasingly develop as an asset class in its own right. The secondary market in Europe currently has compelling pricing characteristics that may become more normalised over time. With a large number of loans coming to the market as banks conform to the new banking regulations, investors can currently command a yield premium over infrastructure loans available in more established markets such as Canada. As the market works through the overhang, this gap will close, although infrastructure debt in both established and new markets will continue to offer long-term investors attractive spreads over LIBOR.
Bob Dewing is managing director in the infrastructure debt group at JP Morgan Asset Management